The Story of Monetary Policy

THE STORY

OF

MONETARY
POLICY

II I? i! !

Awhile later, after interest rales had

risen further, members of the construction

industry demonstrated their unhappiness

by sending some two-by-fours to the

Federal Reserve Board.

I hope the cement

industry doesn't get

angry at the Fed.

What the farmers and the butlders were protesting was the Federal
Reserve's monetary policy. But what ts monetary policy, anyway?

The term "money" refers Co cash in circulation and Che amounts that

people and businesses have in bank accounCs, and "credic" means Che

amounts that banks and other lenders can lend.

We expect the economy to perform in certain

ways — ways that are influenced by what

happens to money and credit. For example,

we expect the economy to grow, so that we

can enjoy a rising standard of living.

In other words, we want the economy to provide an

Increasing amount of aoods and services for each American

to enjoy. Economists call that rising "real GDP per

apita." The phrase "per capita" means "oer oersnn."

cap

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REAL GDP PER CAPfTA

"GDP" stands for gross domestic product, the dollar value of the
nation's output of goods and services. Over time, GDP rises for
two reasons — one is that the economy's output increases,
and the other is that prices rise.

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REAL AND ^OMI^AL GDP

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"Real" GDP data eliminate the effects of the price
increase and thus show only the changes in actual output.

We want the economy to grow, not only to

give us a rising standard of livmg, but also

to provide jobs for people who enter the

labor force each year.

Growth is one of our economic ioals. Another is price stability. We

want to avoid an inflationary economy — where you have a sustainec

and rapid increase in the price level.

Inflation is undesirable for several

reasons. One is that inflation is

unfair and maizes some people worse

off because their incomes don't

rise as rapidly as prices.

Inflation also hurts people who lend money at interest
rates that are lower than tlie rate of inflation.

Another way in which inflation hurts is by making
It harder for businesses to plan.

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Inflation sometimes feeds on itself; one set
of price increases lead; to another.

If unchecked, Inflation can lead to hyperinflation,
in which prices rise extremely rapidly.

Hyperinflation has occurred a number

of times — for example in Hungary after

World War II, Argentina in the

19B0's and Brazil In the 1990s. Some

episodes of hyperinflation

have led to great social unrest.

Money and credit must grow

at a pace that allows
economic activity to expand
at a sustainable rate without
excessive price increases.

If money and credit grow too slowly,

people and businesses will not be

able to get the loans they need for

new homes and equipment.

Id really like to
expand my business, but
I can't afford to pay the higher
interest rates you're charging
during this period of stow
money growth.

The lack of funds for loans will, in turn, lead

to stow growth in the economy, or even to

recession — a period in which the output of

the economy actually declines.

The rise in unemployment that occurs during a
recession brings hardship to many people.

If money and credit increase too
rapidly, the result will be inflation.

The responsibility for making sure that the nations

money supply grows at the appropriate rate lies with

the nation's central bank, the Federal (Reserve.

^

There are several different parts of the Federal Reserve System ("the Fed" For sfiort), and they play

different roles in determining and carrying out monetary policy. The Fed is headed by the Board of

Governors in Washington, D.C. The seven governors are appointed to 14-year terms by the President

of the United States with the approval of the U.S. Senate.

One governor's term expires at the end of January
each even- numbered year. The scheduling makes
it unlikely that any U.S. president would appoint a

majority of the seven Fed governors in one term. Of
course, if a governor resigns before the end of a term,

the president gets lo make an interim appointment.

The staggered 14-year terms help insulate the

Fed from day-to-day political pressures. Unlike most

other government officials, the members of the

Federal Reserve Board, including the chairman,

keep their jobs when a new U.S. president comes

into office, and they can't be fired because of

policy differences with the president.

Another factor chat insulates the Fed from political pressure is its nonrellance on

appropriations from Congress. The Federal Reserve's income consists mainly of the interest

that it receives on its large holdings of U.S. government securities.

It's important for the Fed to be free of short-term
political pressure as it fights inflation. Indeed,

some research shows that the more independence

a nation's central bank has, the more success

the country has in avoiding inflation.

The reason that a central bank needs independence is

that fightina inflation requires actions that limit the

grov^th of money and credit, and those actions

may cause some temporary — but unpopular — business

slowdowns and unemployment in the economy.

White the Fed's

decision making is

Independent, the head

of the Federal Reserve

Is required by law to

present testimony

explaining the Fed's

monetary policy plans

to Congress twice a

year. Congress invites

the chairman to testify

at other times, too.

In addition to the Board

o( Governors, the Federal

Reserve System also consists

of Federal Reserve
Banks around the country.

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The seven memt>ers of the Board of

Governors and the presidents of

five Reserve Banks are the voting

members of the Federal Open Market

Committee (FOMC). The FOMC meets in

Washington, D.C, eight llmesa

year, to determine the course of

monetary policy.

The president of the

Federal Reserve Bank

of New York is always a

voting member and serves

as vice chairman of the

committee, while the

presidents of the other

Reserve Sanfis serve

one-year terms on a

rotating basis.

Before reaching its decision, the FOMC

studies a v/ide variety of economic and

financial data. The committee has to

consider, for example, how rapidly the

economy is growing and whether Inflation

appears to be a problem.

The committee also considers the

analyses that the Federal Reserve

Banks prepare reporting

on economic conditions within

their districts.

After reaching a decision on what
monetary policy to pursue, the FOMC

sends instructions to the domestic

money market desk ("the desk') at the

Federal Reserve Bank of New York,

which has the responsibility for

executing the FOMCs policy.

The FOMCs tnstnjctions include

a target for the federal funds

rate, the interest rate banks

charge one another on short -term

loans of excess reserves.

The desk works to keep the federal funds rate at, or

near, the FOMCs target by buying and selling U.S.

government securities, which are lOU's of the federal

government, and certain other types of securities. The

desk conducts these transactions electronically.

The desk's transactions take place with a number of
securities firms that are designated as primary dealers.

These are securities dealers authorized by

the Fed to engage in transactions with the desk. How

does the Fed flecide which primary dealers to buy

securities from or sell to on a particular day?

When the Fed wanis to buy securities, It asks the

primary dealers which securities they choose to sell to

the Fed. The desk Chen selects Chose securities that

best meet its needs for chat day.

The Fed's buying and selling of securities is

known as "open market operations." The term

■'open market" means Chat Che Fed decides which

securities dealers it wilt do business wich on a

parCicutar day. The choice emerges ffom the

"open market" in which dealers compete on the

basis of price and other characteristics of the

securities they buy and sell.

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Open market operations are intended mainly to

offset fluctuations in ban!* reserves that result

from seasonal or other technical factors.

If the Fed didn't counteract these influences, short

lived, but undesirable, changes in short-term interest

rates might result. One such influence might be a

change in the amount of casli people want to hold.

The amount of cash that Che public holds is

not constant. It increases, for example, during

busy shopping seasons.

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When people withdraw cash from banl<s — to go

shopping, for example — bani(s' reserves and the

amounts they can lend decline.

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If the Fed didn't act to
offset the decline by buying

securities and thereby

adding reserves to the
banltjng system, the result
could be a drop in money

and credit and a rise in

interest rates that could

curtail economic activities.

The Fed does act, though, during the times of the year when bank reserves are low. During those times, the Fed

often buys securities to boost bank reserves. When reserves are unusually high, the Fed often sells securities to

temporarily absorb, or drain, some reserves from the banking system. Thus, the Fed tries to keep bank reserves,

money and credit, and the economy on a smooth and appropriate path.

The Fed was especially busy buying securities tn

late 1999, when people took a lot of cash out

of banks because of worries about possible

bank computer problems In January 2000.

In addition to open market ooe rations.

the Fed has two other major

monetary policy tools: reserve

require
TO

ments and the discount rate.

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Reserve requirements are the portion of deposits that banks have to keep either on hand or on

deposit at a Federal Reserve Bank. For example, if the reserve requirement is 10*, a bank that

receives a S100 deposit may lend %'}0 of that S100, but it may not lend the other $10.

Whoever borrows the S90 is likely to pay someone who wilt deposit the S90 in another bank. That bank in
turn, can lend VOX of S90, or S81. Then the bank that gets the S81 deposit can lend 90* of S81 , or 572.90.

Through this process, the banking system creates money; the level

of reserve requirements influences how much money banks can

create. The higher the reserve requirements, the greater the

restraint on bank lending. If, for example, the reserve requirement

were US, the banks receiving the S100 deposit could lend only S86.

and the bank receiving the SB6 deposit could Send only S73.96.

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10% RESERVE
RFOLIIREMENT

The Monetary Control Act of 1980 authorizes

the Fed's Board of Governors to set reserve

requirements no lower than B% and no higher

that 14% on chectiing accounts.

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In April 1992, the Fed cut the requirement from
12* to 10*. Why do you think the Fed did that?

One reason, according to the Fed, was to put
banks "in a better position to extend credit."

Changes In reserve requirements are infrequent,

though. As of 2006, some 14 years had gone by

without a change.

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We weren't even

born yet the last timel

reserve requirements j

were changed.

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One reason they are infrequent is that reserve

requirements impose a cost, which is like an added

tax on banks —a cost that other types of financial

firms do not have to bear.

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The third tool of monetary

policy is the discount rate,

the interest rate at which

Federal Reserve Banlts make

very short-term loans to

banks. Banks can borrow

from the Fed for any reason.

The rate charged by the Fed
is higher than the federal
funds rale, so banks typi-
cally prefer to borrow from
one another whenever it is
prudent to do so.

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An increase In the discount rate is seen as evidence of the Fed's aim to slow the pace of

economic activity — perhaps in order to prevent Inflation. A decrease in the discount

rate is regarded as evidence of the Fed's aim to stimulate the pace of economic activity.

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For example, toward the middle of 2005, the FOMC raised the discount rate repeatedly

in small steps. These increases removed some of the potential for future inflation

caused by very low interest rates stimulating the economy unnecessarily.

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17

By using open market operations, reserve requirements and the discount rate, the
Fed influences the cost and availability of money and credit in the economy.

Over the years, changes in the relationship between the money supply and the economy have complicated the Fed s job
of formulating monetary policy. For many years, changes ir the economy were closely related to changes in a money
supply measure called Ml , which consists of currency in circulation and checking accounts at depository institutions.

CLOSE RELATIONSHIP BETWEEN M1 AND OUTPUT

In the 1980s, though, when banks started paying Interest on checking accounts,

people put a lot more money into checking accounts. As a result of the rapid growth

in M1 , the relatfonshtp between M1 and the economy broke down.

PERCENT GROWTH
30

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I960 1965 1970 1975 1980 1985 1990 1995 2000

2009

Similarly, the relationship between M2 (a broader measure that includes savins accounts as well as

M1 ) and the economy broke down in the early 1 990s, when Interest rates were Tow. During this time,

people pulled money out of saving accounts and put it Into financial investments outside of banks —

in investments such as mutual funds that are not included in the money supply.

/^ At least for the
/ time being, M2 has been '
I downgraded as a reliable
\ indicator of financial
\ conditions in the
St/\^^ economy.

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The Fed does, however, pay attention to a

large variety of economic and financial data in

making Its monetary policy decisions.

For example, the Fed considers changes in

employment in the United States, as well as

movements in the unemployment rate, which

tells us the percentage of the people in the

country who want jobs but don't have one.

The unemployment rate is related to the build-up of

Inflationary pressures. For example, when

unemployment Is low and firms want to expand

production, they may not find the key people they need

at current wage levels. Instead, they may have to pay

their own workers higher overtime pay or offer wages

high enough to aitract workers from other firms.

The Fed also looks at a

variety of inflation

measures, including the

consumer price index

(CPi), which measures

changes in the prices

that consumers pay for

things tike food,

clothing, rent and

entertainment.

Sometimes, chanHes ui the prices of commodities, such as lumber and copper, that are
used in the production of many other items can provide early warnings of inflation. '

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international considerations complicate the making

of monetary policy. In particular, international forces.

Including policies of other countries, can have substantial

effects on the dollar e«change rate and U.S. interest rates.

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In recent years, international trade and international
financial activity, such as U.S. bank lending abroad,
have grown rapidly. As a result, the Fed has to be

concerned about the value of the dollar, as measured
in terms of foreign currencies.

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When the dollar is strong,

Americans find foreign goods

cheaper to import.

American goods are more expensive, though, so foreigners may

buy fewer of them, reducing U.S. exports and jobs. When the

dollar is weaker, foreigners find U.S. goods cheaper to import,

so U.S. industries can export more.

A weak dollar can aggravate

inflationary pressures in the

United States.

Interest rates are one factor affecting the value of

the dollar. For example, when interest rates are

higher in the United States than elsewhere, foreigners

want to invest their funds here in order to earn a

higher rate of return. The increased demand for U.S.

bonds pushes up the value of the dollar.

I

Making monetary poiicy is a complicated job,

but it's a job that s necessary in order for our

economy to enjoy continued growth along

with stable prices.

"The Story of Monetary Policy" uses non-
technical language and lively Illustrations
to explain:

■ the meaning and purpose of
monetary policy,

■ how the Federal Reserve makes
monetary policy,

■ what factors the Fed considers in
making monetary policy,

■ the tools of monetary policy —
open market operations, reserve
requirements, and the discount
rate — and how they work.

For more information about

New York Fed education

prograrr)s, visit:

www.newyorkfed.org/education

Federal Reserve Bank of New York

Public Affairs Department

33 Liberty Street

NewYork, NY 10045

(212) 720-6134

NOT FOR RESALE

For free copies, visib

www.newyorkfed.org/publications

Reprinted
2006